How Diversification Is Supposed To Work

Let's start with this.

If inflation continues to run at about 3.5% then that implies a real return of 3.5% versus 4.56% real return for Vanguard Balanced Index Fund (VBAIX) since inception or 5.97% real return for the last ten years. The real return coming down to 3.5% might be disappointing but it's not catastrophic. Getting an extra 50 basis points with alts would be helpful if the other assumptions turn out to be correct. 

Coincidentally, Finominal's Monday research looked at diversifying with gold, managed futures and bonds.

The first thing I wondered is why not run the same test with all three in one portfolio?

The first four portfolios allocate 60% to the S&P 500. Splitting the 40 between gold, managed futures and bonds does what it should. Volatility and the max drawdown both drop some and the CAGR is neither the best of the lot nor the worst. This is simply the building block of understanding that there's no reliable way to guess which diversifier will work the best and that by diversifying your diversifiers you should get exactly what we got with this exercise. 

On a related note, Matthew Bartolini from StateStreet was on ETF IQ and he had some interesting things to say about portfolio construction. Eric Balchunas said that bond funds like AGG are not providing the type of diversification that they used to. Bartolini had some stats to validate Eric's point but nonetheless, bonds don't do it anymore, so what does StateStreet suggest?

He talked about replacing AGG-like exposure with derivative income funds, high yield and bank loans. 

This last backtest only covers five years, going back to when bonds became unreliable. The yield didn't adequately compensate for the risk and volatility long before five years ago but five years ago is when it started to matter. 

Kudos to Bartolini for thinking outside the box. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.